Everything's Going To Zero

Put differently, when the value of the asset drops below the value of the debt used to buy it, poof.

For example, let's take a back-of-the-envelope look at the housing market. A couple of years back, the value of US residential real estate was about $20 trillion. Mortgage debt constituted about 45% of that ($9 trillion) and owner equity 55% ($11 trillion). (Very rough numbers)

Now, the value of the US housing market is down 21% and headed to, arguably, down 40%. In other words, if the peak value was $20 trillion, the current value is about $16 trillion, and the trough value will be about $12 trillion. So what will happen to homeowner equity?

PEAKValue: $20TMortgage Debt: $11THomeowner Equity: $9T

TROUGHValue: $12T Mortgage Debt: $11THomeowner Equity: $1T

The good news: It won't go to zero! The bad news: with 45% debt-to-value, a 40% drop in value will reduce equity by almost 90%. Ouch. And by the way, that percentage holds regardless of what the actual peak value of the housing market was, as long as you start with 45% debt-to-value.

And what happens if you have a more typical debt-to-value ratio--say, 80% debt? Then, unfortunately, your equity IS going to zero. In fact, it will only take a 20% fall in the house price for that to happen:

(By the way, this is what just killed all those Wall Street banks. Unlike consumers, they didn't have 45% debt-to-value ratios or even 80% debt-to-value ratios. They had 97%-debt-to-equity ratios. So it didn't take much of a decline in equity to blow them to smithereens.)

What about stock portfolios?

The worst peak-to-trough stock market drop was 1929-1932, when the S&P 500 dropped 86%. Horrific, but not zero. (Unless you were carrying margin debt). But here's keeping our fingers crossed that the S&P 500 won't drop 86%, which would be another 60% or so from here. (Given the government's aggressive response to the crisis, we think this is very unlikely).

And, to close on a happier note, here are some things that almost definitely aren't going to zero:

Consumers that have enough cash flow that they won't get forced out of their houses when their equity is zero (the house prices will eventually recover, and then the same leverage will work on the upside).

Investors who don't panic and sell stocks at the bottom. As long as the portfolio is diversified and the companies don't go bankrupt--see below--the prices will eventually come back.

Companies with no debt and strong cash flow that would still generate cash if you cut their revenue significantly.